Transferring Your Parent’s House Creates A Conundrum

In the majority of cases where the parent transfers a house to their child during their lifetime, it creates a capital gains conundrum. The child receives an immediate benefit when receiving the house because the state of California does not reassess the value of the home for tax purposes on a parent-child transfer. (It doesn’t reassess on a child-parent transfer either.) Therefore, the child pays no increased property tax. But, if the child wants to sell the house their parents gifted to them, they are going to be hard hit by long term capital gains.

Suppose your parents bought a three bedroom house in 1956 for $10,000 and it is now worth $680,000. Those used to be very realistic numbers in southern California before the crisis, but helps illustrate the point. Your parents have been renting the house for profit during the last three years, and now decide to gift the house to you.

When they transfer the title to you, there will be no change in the cost basis of the house. (That is the amount your parents paid for the house in 1956.) Your parents “cost basis” of $10,000 carries over to you and therefore you pay no higher property tax on the property than they did. Your cost basis is now $10,000.

What happens if you want to sell the property? With a cost basis of $10,000, you would pay capital gains tax on an $670,000 gain after a sale for $680,000.

The federal capital gains tax brackets are complex and shifting, but as of 2008, the gain on property sold on or after May 6, 2003, is taxed at a rate over 15%, and said to be going to 20%.

The California state income tax brackets are the same as the state capital gains brackets. Therefore, a single person with a capital gain of over $40,000, and a married couple with a capital gain of over $80,000 will pay the highest rate of tax California has which is 9.3%.

The math on the property works out as follows:

$680,000 fair market value
$680,000 sale
- $10,000 cost basis

$670,000 gain
- 15% Fed. tax = $100,500
- 9.3% state tax = $62,310
____________
$162,810

You will be responsible for paying $162,810 in taxes if you sold the house at today’s fair market price. It takes many years of property tax to add up to that number and justify the loss of the step-up value you would receive if you inherited the house upon their death.

Therefore, one alternative to paying this $162,810 in taxes is to wait to inherit the property after your parent’s death. At that point there will be a “step up” of the cost basis to the fair market value of the house as of the date of death. The cost basis of $10,000 will step up to the sale price of $670,000.

If you sell your parents’ house immediately after their death, there would be no capital gains taxes on the sale, if the house did not appreciate in value from the date of death.

This would all seem a little callous if you actually put gift deferment and tax avoidance ahead of the death of your parents. But the beauty of estate planning is recognizing the financial reality of these basic tax consequences and making the best of them –- and not being rudely surprised.

For example, according to IRC 121, if a married couple has owned and occupied a house for two out of the last five years, they can exclude the first $500,000 of their capital gain from taxes. (It is $250,000 for a single person.) But they now apportion the amount of years you live in the house over the last five years.

In the scenario above, your parents could have sold the house they moved from three years ago and paid taxes using their IRC 121 exemption and walked away with a gain of $500,000 tax free.

And if a single homeowner was required to move into a nursing facility due to health reasons they can deduct the first $250,000 of capital gain if they lived in the house one out of the previous five years.

Unfortunately, this plan may be outdated by 2011 as it is rumored Congress is passinf a new estate plan law where the heir receives the cost basis and has to pay the capital dains anyway.